It should come as no surprise that there are many investors who believe that the primary obligation of the Federal Reserve is not to preserve the value of our currency but the values of their portfolios. But what was surprising is that so many of them also believed, at least until yesterday, that the Federal Reserve shared this tenet of their bullish faith. And when the Fed yesterday seemed to announce its heterodoxy they reacted by all but calling for the a burning of the heretics, who they were suddenly dismissing as “ivory tower” egg-heads. If only the Fed was run by more of their kind—investment fund managers and equity traders—it might make its operations more convenient to their strategies and force the markets to behave according to their models.
But it seems the governors of the Federal Reserve have redeemed themselves in the eyes of the Wall Street faithful, at least for a few hours, with the announcement today of a temporary “term facility auction.” You will be forgiven for not immediately understanding why this new creature marks the return of Ben Bernanke’s congregation to communion with Wall Street. Indeed, so new is the Term Facility Auction that never before has that phrase been uttered by a speaker of the English language—or at least, it has not before today appeared on that vast collection of their words we call the world wide web. A google search for the phrase turns up nothing before today’s announcement.
So what is this term facility auction? Our answer after the jump.
Very little about it seems understood except that there will be four auctions and they will deliver at least $40 billion from the coffers of the Federal Reserve into the marketplace. The mechanism for the delivery of these funds will be auctions in which banks will bid for funds by offering the highest interest rates they will pay for them. Those bids will likely be lower than the discount rate—otherwise the banks would simply borrow from the discount window. So, in effect, the term facility auction offers a super-discount window to the banks with at least $40 billion on offer.
But even less understood is how this operates as a lifeline—let us not use that dreaded word bailout—to some of the most troubled corners of the credit markets. As collateral for the loans offered under the TFA, banks will turn over to the Fed collateral. But unlike the kind of collateral the Fed demands in its ordinary open market purchases, here the Fed will accept a far wider variety of collateral. While the Fed will not take just anything—for instance, don’t try to put up your marked-to-myth portfolio of recently downgraded CDOs—it is willing to take a variety of debt securities that few others in the market have expressed much interest in acquiring, except perhaps at the kind of steep discount that Citadel got from E*Trade.
In exchange for its billions, for instance, the Federal Reserve will take AAA rated asset backed and commercial mortgage backed securities, and give you credit for 92 cents on the dollar. It will also take your AAA rated CDOs, for that matter. And if you are concerned because the market for CDOs has been so arid lately that you do not believe there is a market price for your CDOs—or, perhaps, you believe with the executives of UBS that your CDOs cannot be priced because they are likely Heisenbergian particles that change under observation—the Fed has holy words for you: Be Not Afraid. It will give you credit for 85% of the par value of these securities. How about some asset back securities that are rated below AAA and for which you cannot determine a market price? The Fed will take those for 80% of par. Got some commercial paper you need to convert into cash? The Fed will give you 95 cents on the dollar. The full range of values the Federal Reserve will assign to various asset classes can be downloaded in a handy Excel spreadsheet available here.
The short term effect of this will be to create a market for a class of debt securities that have few buyers and held by banks too frightened to attempt to sell them. It assigns a value—80% of face value—to CDOs which, despite their high credit ratings—have frustrated every attempt by banks to value them at what they believe are reasonable prices. And it replaces these illiquid assets with a very liquid asset known as cash. It also shifts some of the short term risk of downgrades in CDO credit portfolios from the institutions currently holding them to the Fed. In effect, the Fed has become a buyer of CDOs and asset backed securities.
The long term effects will have to be seen. The Fed is buying this paper but the banks will have to promise to buy it back at the end of the term. The repricing of risk that has diminished the appetite for these assets will not likely be undone by the facility, and so this could simply forestall a reckoning of their values. Of course, if an organic market for these things has not yet revived by the time the term of the facility is over, the Fed could very well launch another term facility and allow the bank to roll-over the initial “loan.” There are already whispers that this temporary term facility could become a permanent tool of the Federal Reserve.
It would probably have been more descriptive for the Fed to have called this the Master Liquidity Enhancement Facility, if that phrase did not share so many terms with the ever-shrinking super-SIV cooked up by Citigroup and its friends in the Treasury department. Instead they brought into our collective lexicon a new phrase—Term Facility Auction—and we suspect it is a phrase that we will get to know very well over the coming months and, perhaps, years.